The CPA Journal

PLANNING FOR INCENTIVE STOCK OPTIONS

By Barbara Latwin, CPA, D’Arcangelo & Company LLP

Deferred compensation funded by incentive stock options (ISO) creates a number of planning issues.

What are the federal tax ramifications of exercising and selling an option? Simply put, because an ISO generates taxable income only when it is sold, the benefit of receiving an ISO is the choice of when the “taxable event” will occur. The reality, however, is a little more complicated and must be examined over a multiyear period.

When an ISO is exercised, the employee does not generate regular taxable income; rather, there is an alternative minimum tax (AMT) adjustment for the difference between the fair market value of the stock at the date of exercise and the exercise price of the option, multiplied by the number of shares. This adjustment could result in paying the AMT, but the taxpayer would have an AMT credit carryover to future years. Upon exercising the ISO, the employee will have to keep a record of two tax bases: the exercise price of the option and the AMT basis (i.e., the fair market value of the stock on the date of exercise).

When the employee sells the stock, the gain is recorded as the difference between the sales price and the exercise price. (In order for the gain to qualify as long-term, the stock must be held for more than one year after exercise and more than two years from grant.) For AMT purposes there is reversal of the AMT adjustment made at the time of exercise. A credit for AMT paid in the year of exercise may lower the tax liability for the year of sale. If the AMT credit is not used at this point, it is carried forward to be used in any year that the taxpayer is not subject to the AMT.

In some cases, the cost of exercise and the additional taxes resulting from the AMT create too much of a financial burden. It is not uncommon for an employee to take out a loan to exercise the stock option. The interest on the loan becomes a tax deduction to the extent of investment income.

To offset the costs of exercising, the employee may wish to sell at least part of the exercised shares. The difference between the exercise price and the sales price will be subject to ordinary tax rates, but there is no AMT adjustment on those shares. For many ISO holders, the optimal scenario is to sell just enough of the exercised shares to cover the cost of exercise and to pay the taxes.

If the employee owns shares of the company outright, he could “swap” enough of those shares to pay for the exercised shares in a nontaxable event. This would be another way of exercising without costing the employee additional funds. Not every plan permits swapping, so it should be explored carefully.

When should the employee exercise the options? Because the employee must decide when to exercise the granted options, there are opportunities for planning. Many experts advise waiting as long as possible to exercise if the market value of the stock is likely to increase. This advice is especially wise if the employee would need to sell other securities to pay for the exercise or sell prior exercised lots to pay for the current exercise. By delaying exercise until the expiration of the grant, the employee is riding the increase in the market of all the securities. The decision to exercise also may hinge upon the employee’s tenure with the company. Examination of the company’s ISO compensation plan should precede action.

How long should the employee hold exercised options? To generate long-term capital gain, the employee should hold an exercised option for at least one year from exercise and two years from the date of grant. Of course, market conditions might cause an earlier sale. After holding the stock for more than one year, the employee should consider whether the stock will continue to increase in value, how much of the stock should be kept, and whether it is necessary to sell the previously exercised stock to pay for a new exercise.

Lacking cash, many technology companies have been using options as a large part of employee compensation. Unfortunately, the price of these stocks has fallen and many employees are holding losses, leaving them with few options: sell the stock and take the loss, invest in other companies in the same industry, or wait 30 days to avoid the wash sale and reinvest.

When and how should the employee diversify? What does an employee do when most of the portfolio is tied up in the employer’s stock? The employee might consider putting a portion of the stock, held for at least one year, into a charitable remainder unitrust (CRUT). The employee would make the charitable contribution and the CRUT could sell the stock, diversify, and pay the unitrust amount annually to the employee. This course of action would work especially well if the stock has appreciated significantly.

The employee could also consider gifting the exercised shares to family members (granted options that have not been exercised cannot be gifted). The employee would then keep track of both the regular and AMT bases.

Editors:
Milton Miller, CPA
Consultant

William Bregman, CFR, CPA/PFS

Contributing Editors:
Theodore J. Sarenski, CPA
Dermody Burke & Brown P.C.

David R. Marcus, JD, CPA
Marks, Paneth & Shron LLP

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